Prudent portfolio construction begins with a strategic asset allocation. The asset allocation is comprised of different asset classes such as stocks (large, small and international), and bonds (short-term, intermediate,and long-term maturities of varying investment grades). We identify how much risk we are willing to bear by targeting a certain percentage of stocks and bonds and than purchasing the best components in each asset class. So the asset allocation is the recipe for the portfolio and the components are the ingredients. Most investors ignore the recipe of their portfolio and focus on the ingredients by chasing returns. They buy the top five performing funds in their 401k plans (which are commonly in the same asset class) or the latest outperforming star that they read about on the internet.
Top performers last year are rarely the top performers this year. This phenomenon is known as “reversion to the mean”. One year stocks will outperform, another year bonds will. When investors are scrambling all over each other to buy or sell the asset class it is usually too late. The good or negative event has already happened. Each year the asset class that investors love , or revile, is different.
Imagine what a pot of gumbo would taste like if you grabbed the most popular ingredients du jour and threw them in the pot. No measurements relative to the other ingredients, just a handful of this and a handful of that because they are the current hot performers (i.e. tech stocks, real estate, gold). Over time the concoction in the pot wouldn’t resemble what it could have been had it been constructed with a recipe, which provide structure and discipline for the ingredients. Over time, the end result might not be palatable, merely a pot of mush.
Set reasonable goals, then design a strategic, long-term asset allocation based upon your time horizon to fund your future retirement liabilities and your risk tolerance. Once you have determined the recipe for success, populate it with the best ingredients: low-cost indices and good mutual funds.
Occasionally, you need to adjust the recipe. Your appetite for risk changes over time and opportunities do as well. Maybe the gumbo needs a little more heat, maybe it needs to be toned down. I’m in the midst of that process right now. I’m tasting the gumbo and I’ve already identified some new ingredients that will improve the flavor and the long-term outcome for our clients.